Deloitte Japan Charged With Violating Auditor Independence Rules

Posted: August 25th, 2021

Deloitte Japan Charged With Violating Auditor Independence Rules

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Deloitte Japan Charged With Violating Auditor Independence Rules

Introduction

Even as criminal prosecutionsin cases related to financial reporting continue to attract the global attention, recently organized private litigationstake place with a focus on private and public corporations. The war targets companies, their board members, the managers, audit firms, and any other parties believed to have facilitated financial reporting malpractices (Ball, 2009). Unlike the criminal process, civil litigation is a market process intended to enforce implicit and explicit contracts among different stakeholders, including the auditors and other contracting parties. Between the years 2000 and 2007, various organizations have paid more than $50 billion as a settlement for damages insecurities lawsuits (Ball, 2009). In the case of Deloitte Japan, theviolation of the auditor’s independence has led to severe financial loss and damage to the overall reputation of the company.

An Overview of the Event

Deloitte Touche Tohmatsu LLC, popularly known asDeloitte Japan, has been under investigation for some time due to questionable financial relationships with its audit client. On February 13, 2019, the Security and Exchange Commission (SEC) declared that the company would pay approximately $2 million for infringement of auditors’ independence rules. The announcement came at a time when Deloitte Japan was under scrutiny for allowing some of its employees to run bank accounts with the client’s subsidiary. In its report, the SEC established that the doubtful accounts held balances above depository insurance limits; hence, it was the violation of the stipulated SEC auditor independence rules. 

Complying with auditor independence is necessary in financial reporting sphere. However, in Deloitte Japan,dozens of its employees were maintaining bank accounts with their audit client, holding balances more than the limits indicated by FDIC. Futomichi Amano, the former Chief Executive Officer, and Yuji Itagaki, the former Director Independence and Reputation and Risk Leader, were both found responsible for the violation and have topay $2 million charge in full. Even though Deloitte Japan had prior knowledge about the implications of such engagements, it still allowed the situationto happen anddid not discloseit to the relevant authorities for appropriate actions to be taken. For instance, the organization failed to reveal that Amano, together with other 88 workers, engaged in a financial relationship with their audit client thereby compromising Deloitte’s independence. Besides, the SEC’s order discovered that Deloitte Japan’s quality system failed to provide proper assurance on the absence of engagement between its internal auditors and the external clients. After evaluation of all possible violations, the significant implications included Deloitte Japan’s acceptance to pay the $2 million in monetary sanctions. Furthermore, Amano and Itagaki accepted the suspension from practicing as accountants for the next two years and one year, respectively.

Discussion of the Relevant Law: A Rule by the Securities and Exchange Commission

Over the past few weeks, the Securities and Exchange Commission reviewed its regulations, providing mechanisms for appointment and removal of the hearing officers of the Public Company Accounting Oversight Board (PCAOB). This law originated from The Sarbanes-Oxley Act of 2002 (the Act) which established the PCAOB to preside over the audits of companies guided by the securities laws (Securities and Exchange Commission, 2019). The principal objective of this regulation was to ensure that all organizations protected the rights of investors and served the interests of the public by preparing comprehensive, independent, and informative audit reports (Securities and Exchange Commission, 2019). Thus, to make sure that the PCAOB is compliant, the Act vested the Securities and Exchange Commission with the power to oversee and enforce various public corporations. Under this stipulation, the Commission has some critical mandates to execute (PCAOB, 2019). First, it can appoint and remove members of the Public Company Accounting Oversight Board. It can as well set and approve rules and professional standards guiding the operation and performance of the PCAOB among other responsibilities.

In section 105 of The Sarbanes-Oxley Act, the Securities and Exchange Commission allows the PCAOB to investigate, and where possible, execute disciplinary actions against those involved in auditing malpractices (PCAOB, 2019). The final decision targets registered accounting firms, their auditing clients, and any other associated personnel – managers or employees (PCAOB, 2019). Upon the completion of investigations involving financial report misappropriation, the Board holds a hearing exclusively to determine the implicated organizations as well as the involved individuals (PCAOB, 2019). The Board, through the powers assigned to it by the Commission, makes a decision on the best punishment approach based on the violation of any of the following: the Commission’s rules, The Sarbanes-Oxley Act, the professional standards or the securities laws.

An Analysis of the Event

Reputational effects have negative influence on market presence by the private and public organizations. The PCAOB together with the Security Exchange Commission can influence a company’s reputation by imposing penalties on individuals and firms found to have acted against The Sarbanes-Oxley laws. This is typical with the incidences like the Deloitte Japan’s one. According to Saito and Takeda (2014), The Sarbanes-Oxley Act 2002 created PCAOB to help restore the confidence among the general public in the US auditing system and to control the activities of foreign branches. Unfortunately, Deloitte Japan failed to properly implement quality control systems. A working structure needs an appropriate number of employees, an aspect that was seemingly missed in the case of Deloitte Japan. The Office of Independence was understaffed, giving enough room for unauthorized transactions to occur. The two employees, Amano and Itagaki, collaboratively deposited significant amounts of money into the client’s accounts, which resulted in a violation of independence rules. And, as Ball (2009) indicated, the earnings management undermines the quality of financial audits.The case in Deloitte Japan tarnishedthe company’s image in the local and international levels.

In essence, the independent auditors play a vital role in any company intending to compete effectively in the capital market. While making remarks on independent auditors’ function, Harris (2016) highlighted that theworkof these specialists is important in the provision of objective third party judgment on the integrity of the accounting statements. He argued that the financial data provided by these specialistsare essential as investors rely on them to make a definitive decision on their investment plans (Harris, 2016). Unfortunately, the decision made by the Deloitte Japan’s management and some of its employees to maintain bank accounts with the client’s subsidiary was a big mistake. The company further violated the Security Exchange Commission’s audit rules by allowing its accounts to be accommodatedover the depository limits. As the Board has already expressed its verdict on the irregularities at Deloitte Japan, it will affect the image of the firm and damage its reputation as a company towork with. That is, it becomes instrumental for the organizationin any country to prioritize sustainability reporting as a subject of credibility.

As indicated previously, accounting scandals, especially those involving reporting negligence and fraud, encourage the Commission, the Board, and investors to monitor the levels of compliance and trustworthiness of the auditing companies. For instance, when Deloitte Japan allowed its employees to work with theirclient, it was a clear sign of fraudulent financial reporting rules violation, which the company knowingly failed to comply with (Ball, 2009). According to Ray Ball (2009), failure to disclose some of the most crucial aspects of financial reporting damages the values of a company, in this case, the Deloitte Japan. Ball (2009) argues further that gross negligence, which is typical with Amano and Itagaki, is an extreme situation in which employees recklessly disregarded the accepted standards. Therefore, other than the financial loss of the company, Deloitte itself and its employees havediscredited the entire financial reporting system of the firm. Practically, this case seems to harm a more significant segment of the market including the investors, while at the same time, it tends to attract law enforcing agencies to apply penalties through fines and suspensions.

It is important for auditcompanies to focus on strict following of independence rules. In his article, The Auditor Independence and PCAOB’s Investor-Protection, Steven Harris (2016) questioned the effectiveness of firms’ controls and protocols needed to prevent cross-selling or unlawful engagement with the audit clients. Failure by Deloitte Japan to foster a favorable environment for the internal accountants and the contracted firms led to its downfall. For instance, due to lack of proper control, the auditing organization could not prevent the 88 employees from creating an unlawful relationship with the client and exceeding the SEC’s insurance value. The resultant outcome is that Deloitte Japan suffered massively from reputation damage from the international perspective. Whereas there are limited litigations in countries like Japan, auditors should also take responsibilities for their actions. The entire case study does not reveal the identity of the firm in question but instead exposes the non-compliance side of Deloitte Japan. The most appropriate strategy to deal with these scenarios is to ensure the contracted organizations extend diligence in non-litigious environments.

Global Reception of Deloitte Japan’s News

The market response could sometimes be challenging to assess and finalize. However, the Deloitte Japan’s case led to two significant outcomes. Its employees, especially Amano and Itagaki, received penalties for their fraudulence and possible negligence. Besides, as a response strategy to the revealed scandal, the organization began serious adaptive changes to streamline its structural outline to prevent similar incidences from repeating in the future. A litigation process launched against the two managers and the firm indicated that the past actions had affected major stakeholders in one way or another. In particular, the litigants against Deloitte Japan and its top leadership included creditors, labor unions, bondholders, and other workers who were not among the 88 accused employees. In some way, they were affected directly by the continuous release of inaccurate financial reports. Defendants, in this case, the company and its two staff members having confessed of defrauding and malpractice, would receive monetary fine to facilitate the compensation of those who received the harm. By the time Deloitte Japan’s situation will be resolved, its reputation will be questioned. Therefore, given its decline in financial capital and status, it is not any surprise that Deloitte Japan lost many clients.

Who then Wins?

Definitely, Deloitte Japan cannot be the winner in this situation. Upon the revelation of questionable dealings between Deloitte and the contracted auditor’s client, most of other clients would begin mass defection, putting the company under a dire fiscal threat. For instance, when customers who are more visible in the market decide to quit, their reputation follows them to their next destination, making their new organizations the winners. Some of such organizations, for example, have the power to attract more analysts and serious media attention. Others could also have an overall effect on the capital market by providing more security. In any of the above scenarios, losing such a segment of clients would mean high turnover rate and the resultant loss of market share because of the lack of trust, an aspect likely to warrant Deloitte Japan bankrupt.

Conclusion

Deloitte Japan’s case is a typical contemporary threat to auditor independence. While most companies across the world have interacted according to with The Sarbanes-Oxley Act 2002, a majority of them are still struggling to make sure their auditing process is independent and free from interference. Investors and other stakeholders rely on the PCAOB to undertake commercial engagements with different firms. However, when information on rules violation,like inthe case of Deloitte Japan, erupts, a good number of clients opt out and look for other organizations to work with during such moments. While operating in the capital market, companies must focus on their integrity and ensure their financial records are reliable and reproducible whenever the customers decide to retrieve vital information from them. This is the only way to ensure compliance and to solidify self-influence and reputation in the global setup.

References

Ball, R. (2009). Market and political/regulatory perspectives on the recent accounting scandals. Journal of Accounting Research, 47(2), 277-323. doi: 10.1111/j.1475-679x.2009.00325.x

Harris, S. B. (2016). Auditor independence and PCAOB’s investor-protection. Retrieved from

Auditor Independence and PCAOB’s Investor-Protection

Saito, Y., & Takeda, F. (2014). Global audit firm networks and their reputation risk. Journal of Accounting, Auditing & Finance, 29(3), 203-237. doi: 10.1177/0148558×14530128

Securities and Exchange Commission. (2019). Public company accounting oversight board hearing officers. Retrieved from https://www.federalregister.gov/documents/2019/04/03/2019-06427/public-company-accounting-oversight-board-hearing-officers